The UK and Europe: Brexit, rules of origin and barriers to trade

Where is the phone in your hand actually from? Designed in California, assembled in China, it says. But what about the components: the battery, the screen, the processor? Modern supply chains span continents – sometimes the globe – dipping in and out of countries as value is added along the way. The global factory, atomised among many locations, is mind-boggling to contemplate, it can also make it tricky to determine the provenance of any given product. This throws up a specific challenge for post-Brexit, ‘free-trading’ Britain: preferential rules of origin.

Because of rules of origin, even if the UK enters into a trade agreement with the EU, UK manufacturers embedded in pan-European supply chains are going to face new bureaucracy and costs, with long-run implications for their continued viability.

In brief, to benefit from the preferential tariff rates offered by a trade agreement, a UK exporter must prove that the product it is selling is actually from, or has had sufficient work done on it in the UK (subject to myriad terms and conditions). This is easy enough if the product is wholly obtained in the UK but it becomes more difficult if the product consists of inputs (components) sourced from all over.

For example, in order to sell a car to Korea tariff-free under the EU-Korea trade deal, an EU car exporter must demonstrate that over 55 per cent of the value of the car was created within the EU.

The only way that the UK can remove the post-Brexit rules of origin issue is to remain in the EU customs union, or enter into a new one. Without an EU-UK customs union, rules of origin create three immediate problems for post-Brexit Britain:

1) UK exporters selling a product to the EU27, under any free trade agreement, will be required to prove that the product they are selling is actually from the UK. Rules-of-origin-compliance can be costly. Estimates vary but have been put at between two and six per cent of product’s final value. If a false claim is made the exporter risks being sued by the importer.

These additional costs will reduce the competitiveness of UK exports to the EU vis-à-vis EU27-based producers. The additional border administration will also disrupt just-in-time supply chains, where even those who comply with ease will be held up by those who do not.

2) UK exports that incorporate a significant proportion of non-UK components may struggle to qualify as ‘British’ for a UK-EU free trade agreement. The rules for meeting the origin requirements of a free trade agreement vary sector-by-sector.

Sectors that traditionally find rules of origin burdensome include vehicles, textiles and some food and machinery. The requirements placed on chemicals can also be tricky to navigate.

3) UK exporters currently making use of EU free trade agreements with other countries may be used to complying with rules of origin. But they will face difficulties complying with existing rules if and when the UK replicates the EU’s free trade agreements with third countries post-Brexit. While currently ‘EU value-added’ counts as ‘local value-added’ for the purpose of qualifying for a given agreement, post-Brexit this will not necessarily be the case.

This may of course prove a problem for EU exporters as well. However, EU exporters are far less reliant on UK inputs than the reverse.

Even with a UK-EU trade agreement in place, rules of origin will lead to some UK exporters being less price-competitive in EU markets; choosing not to export at all; or, due to the complexity and/or cost of compliance not being greater than the potential tariff savings, choosing to export under WTO most favoured nation tariff rates. Exporters have under-used trade agreements thanks to rules of origin (as well as failing to realise that a helpful trade agreement exists, in some cases). UNCTAD estimates that only two-thirds of EU exports are sold using the preferential tariff rates available under the EU’s trade agreements. EU exports are subject to additional tariff costs of around $79 billion as a result.

Ultimately, the impact of leaving a customs union is binary. Even retaining membership of the single market via the EEA agreement would not resolve the rules of origin problem (exports from Norway to the EU still have to prove origin). In the absence of a customs union, UK businesses exporting to the EU – many of whom have no experience exporting elsewhere – will face new administrative costs and bureaucracy. Assuming the UK manages to replace the EU’s FTAs, even those companies which now comply with the rules of origin will face new challenges proving that their products qualify. Steps can be taken to mitigate the damage, but rules of origin are one cost of Brexit that no amount of positive thinking and innovative solutions can eliminate.

Sam Lowe is a research fellow at the Centre for European Reform.

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Winner of the Prospect 2015 Think Tank of the Year Award - UK International Affairs